Cryptocurrency tokens boast different functions, each with their own tradeoffs and risks. Holders need to take these functions into account, especially given that they have a strong impact on long-term price appreciation.
Analysts at Smith + Crown have outlined some of the pitfalls of token functions in research published Nov. 18. The examination of the different functions tokens can perform, as well as their associated trade-offs, found that designing a crypto-economic infrastructure can be a daunting task for development teams.
The research company’s analysts outlined six functions that cryptocurrency tokens can have. The list is not exhaustive, but includes the most commonly observed token functions: value transfer, contribution, membership, governance, dividends, and asset backing.
Value transfer is the most common token function. The value transfer properties of a token make it the only — or easiest way — to transfer value or make a payment on the host platform.
The function of contribution refers to allowing token holders the opportunity (or obligation) to perform work or provide services in exchange for being rewarded in that token. One example is Augur, the prediction market, which requires reporters to verify market results or resolve disputes. Augur’s native REP token rewards holders working as reporters through platform fees.
The contribution function of tokens typically requires users to stake their cryptocurrency in proof-of-stake networks.
The membership function gives holders “access to premium features or capabilities on the platform, including membership and discount features.” Governance allows token holders to participate in a network by voting on decisions made regarding the platform in terms of development and other matters.
Dividends are a function among some tokens that offer regular payouts to token holders. These payments can form part of a platform’s revenue or fee-sharing arrangements.
An asset-backed token is “redeemable for or represents claims to an underlying physical or digital asset.” Examples vary from stablecoins (redeemable for underlying fiat currencies or real-world assets) to non-fungible collectibles like CryptoKitties.
The Tradeoffs and Risks Associated With Functions
Most tokens have more than one of the functions mentioned above. Binance’s recently launched BUSD is backed 1:1 by U.S. dollar reserves. It can also be used to transfer value. And while Binance has denied it will give holders reduced trading fees, the exchange has promised that holders will be able to unlock additional financial services within Binance’s ecosystem.
However, creating crypto-economic models that appropriately incentivize users is complex and poses risks. As Smith + Crown stated,
“Token functions have implications for everything from design, use case, the business model of the underlying organization, and valuation methodologies. They present tradeoffs that projects must manage.”
The value transfer function alone, for example, does not incentivize holding. The function is easy to implement and helps establish a clear link between usage and value. On its own, however, holders gain nothing for owning the tokens. Having long-term holders adds price support for a token.
Tokens with contribution functions benefit from decentralizing the development of the host platform and creating a clear link between the health of the network — or at least its underlying protocols — and the value of the token. Holders are incentivized to contribute to the network, which enables the network to grow and develop, ultimately becoming more valuable over time.
Membership functions, on the other hand, tend to require centralized decisions to be made about the benefits and rewards that token holders receive. These functions can also make valuation difficult, as the benefits of membership may have different levels of perceived value among users.
Governance, which allows token holders the right to participate in key decision-making processes for the future of a network also comes with its own problems. While it aligns with the spirit of decentralization and incentivizes good decisions, it is difficult to implement and can be perceived as an insufficient reason to hold the tokens.
The dividend function provides a clear link between the price of a token and its value. Revenue-sharing models, however, present risks to holders and creators. The more a dividend-paying token resembles a security token, the more closely it may be examined by regulators.
Smith + Crown actually found that the distinction between security tokens and utility tokens lacks substance. According to the research, it was not clear that the “differences between ‘utility tokens’ and other types of tokens… [are] a straightforward distinction.”
Value transfer is the most frequently observed function among cryptocurrencies, common among virtually all of the company’s ‘Signal’ tokens (those it considers to be of higher quality).
However, tokenomic models are adapting and evolving. As the industry both matures and develops, those models will become more complex and nuanced. New functions will likely emerge over time as developers embrace alternative models. For network creators and participants alike, it is important to understand the risks involved in different cryptocurrency applications.